Devising a Royalty Structure that Fairly Compensates a Franchisee for Its Contribution to Franchise Goodwill

When a franchise’s ownership and goodwill distribution under afranchising agreement are the subject of a dispute between two parties, thecharacterization of the parties’ franchise relationship is often contested.For example, in disputes arising from issues related to franchise networkcreativity, transfers, and terminations, parties in a franchising agreementtypically make assertions about the nature of their relationship accordingto what they hope to gain from the resolution of the particular dispute,rather than facing the truth about their franchisor-franchisee relationship.Accordingly, these types of disputes have generated a large degree ofuncertainty about the true nature of franchise goodwill, while alsoobscuring how certain components of the franchise business model aredefined.In order to resolve these issues, this Article suggests incorporating a clearset of goodwill guidelines and expectations in franchise royalty structures,which would make franchise goodwill more coherent and transactable.Specifically, this Article proposes adopting a “variable” royalty structure,which would fluctuate in response to the goodwill contribution byfranchisees. Under this variable royalty structure, franchisees’ royaltyrates would decrease in response to above average performance (i.e., afranchisee’s superior “contribution”) and increase in response to belowaverage performance (i.e., a franchisee’s “free riding”). By producing a formal method for computing franchise goodwill, this variable royaltyarrangement could add much needed clarity and consistency to goodwilltreatment in the franchising context. Additionally, franchisors could alsobenefit from this variable royalty structure by incentivizing good franchiseebehavior through systemic goodwill—i.e., providing the franchisee “just”compensation through reduced royalty rates.In short, the proposed variable royalty system intends to simultaneouslybalance power in the franchising relationship, bring consistency to the legalidentity of franchisees, and mitigate franchisee free riding